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Tuesday, 3 March 2015

Ricardo Hausmann argues that Greek spending was "out of control" during the years prior to the Eurozone crisis - which as far as Greece is concerned actually started in 2009 with its first debt crisis, not in 2012 when the whole bloc nearly collapsed. He says:

"Greece piled up an enormous fiscal and external debt in boom times, until markets said “enough" in 2009."

Since the world was in recession in 2000-1 because of the dot.com crash, we have to assume that by "boom times" he means 2002-6 (since the financial crisis in Europe started with the failure of IKB in July 2007). So is he correct?

Here is Greece's debt/gdp from 1981 to the present day:

Nowhere in this chart is anything indicating a vast increase in debt/gdp from 2002-6. The vast increases in debt/gdp occurred prior to 1993 and from 2009 onwards. Greece's debt/gdp was high but stable from 1993 to 2009. Sixteen years of stable debt/gdp does not suggest a profligate government piling up an enormous debt due to out-of-control spending. It does suggest a government that was unable or unwilling to cut its debt/gdp in the boom times, but Greece is hardly alone in that.

Ok, so Hausmann is wrong about the external debt/gdp. Greece's high debt/gdp did not come about during the 2002-7 boom. It dates from the recessionary 1980s.

What about its external debt? Now there was indeed a huge increase during the boom times:

Which was of course because of this:

Yes, that is a large and growing trade deficit. The last time Greece's current account was in balance was in 1995. Hausmann does have a point about Greece's competitiveness. But the damage was done in the years from 1995 to 2001. During the boom years 2002-6 it appears that Greece's current account deficit was actually shrinking. So again, Hausmann is incorrect. Greece's trade deficit pre-dates the boom years.

What about its fiscal deficit? After all, it does appear to have been servicing its debt without increasing it. Here's Greece's government budget to GDP:

Well, this is odd. Greece's debt/gdp was stable until 2009 even though it was running a sizeable budget deficit throughout that period. These figures are of course all ratios, so we need to look at what was happening to GDP during that time. Here's Greece's annual growth rate:

That's really a rather healthy growth rate. No wonder Greece's debt/gdp was stable despite its budget deficit. And no wonder no-one saw the crisis coming. Why would anyone think an average annual growth rate of about 4% for over a decade was unsustainable?

Hausmann's claim that Greece built up unsustainable fiscal and external debts "during the boom times" is clearly wrong. The fiscal debt built up during the 1980s, and the external debt built up during the 1990s. Both were fed by recession. Profligacy there may well have been - but it was a long time ago. And there was no doubt a missed opportunity to reduce the debt burden. But should Greece really be blamed for failing to take advantage of an opportunity that just about every other government in the Western world missed?

Hausmann is also guilty of a cardinal statistical error. He says that "By 2007, Greece was spending more than 14% of GDP in excess of what it was producing, the largest such gap in Europe". Indeed it was. But as the current account to gdp chart above shows, that 14% trade deficit did not gradually build up during the boom years, as Hausmann implies. Greece's current account deficit actually started to decline in 2005, having improved from 2001-4:

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The mirror image of this is of course the increasing inflows of capital from 2005 onwards:

Any analysis of Greece's external position that looks only at the current account deficit and ignores the growing capital account surplus is telling only half the story. Hausmann chooses his data to suit his argument that Greece's problems are all due to its profligate government spending and lack of investment, He ignores the (substantial) role of capital OUTFLOWS from other countries in the Eurozone, notably but not exclusively Germany. And he ignores the fact that the period 2005-7 was characterised by dangerous buildup of credit bubbles throughout the Western world. I've written elsewhere about the Eurodollar ("US-in-Europe") leveraging flow system that burst catastrophically in 2007-8. There was an equivalent Euro leveraging flow system circulating between the core and periphery Eurozone countries. This is what we are looking at in the chart above.

Capital has to go somewhere, and it has to be used for something: and that something is not necessarily productive. In Spain and Ireland, capital outflows from core countries blew up real estate bubbles. In Greece, they fuelled a consumption boom and enabled the government to maintain a high budget deficit. Is Greece's use of those capital flows any more dysfunctional than Spain or Ireland's?
And why was capital flowing to that extent at all? Why was it not funding commercial businesses in its countries of origin? Germany hardly has a stellar investment record either. The truth is that NO-ONE used that capital for investment. No-one at all.

Why are we not blaming this on the banks whose highly-leveraged, unproductive lending caused this collapse? We have been quick to blame banks for the "US-in-Europe" crisis. But we have blamed sovereigns, not banks, for the equivalent "core-in-periphery" crisis. Yet the cause is the same, and as this chart shows, even the timing is the same.

And yet....Greece does have a competitiveness problem. In this Hausman is correct. But the question we should be asking is why Greece's competitiveness declined so much in the 1990s, why it started to improve in the 2000s prior to the development of the "core-in-periphery" leveraging flow system, and what can be done now to restore it. Greece's public finances are a red herring.

Thursday, 26 February 2015

This is the text of a talk given at Manchester University on 26th February 2015 proposing the motion "This house believes that mainstream economics has failed". It was followed by contributions from Trina Watson of the Post-Crash Economics Society (supporting), Dr. Andrew Lilico and Dr. John Ashworth (opposing), and a lively debate.

Since the financial crisis there has been growing criticism
of “economics”. From the Queen’s famous question “why did no-one see this
coming?” to the Occupy movement and now to the Post-Crash Economics society
founded by students at this university, people have questioned the purpose of
an economics profession that failed to see the disaster approaching and seemed
to have little coherent idea what to do about it.

Nonetheless, a blanket condemnation of "economics" as having failed is I think too wide. I therefore wish to narrow the framing. There are many economists out there doing important work, both in industry and in academia, on labour markets, on the
behaviour of firms and households, on trade dynamics, on market functioning. I do
not by any means wish to suggest that these have failed. Microeconomics, as a
discipline, is going from strength to strength. My beef is with macroeconomics.

We in the field did think of the economy as roughly linear,
constantly subject to different shocks, constantly fluctuating, but naturally
returning to its steady state over time. Instead of talking about fluctuations,
we increasingly used the term “business cycle.” Even when we later developed
techniques to deal with nonlinearities, this generally benign view of
fluctuations remained dominant.

The models that macroeconomic practitioners developed
reflected this essentially linear view. Blanchard went on to observe that
although macroeconomists did not ignore the possibility of extreme tail risk
events, they regarded them as a thing of the past in developed countries.
Western governments had inflation licked because of inflation-targeting central
banks. Bank runs had been solved by deposit insurance and central bank lender
of last resort functions. Sudden disastrous reversal of capital flows and balance of payments crises were
problems for emerging market economies, not for developed European economies. And
anyway, central banks could prevent or stop market “panics” by flooding the
place with liquidity. If you get the policy settings right, linear models will
work.

Except that they won’t. And that is because these models are
not realistic views of how the economy actually works. Representative agents
aren’t actually representative of anyone. Rational expectations are driven as
much by emotion as logic. Behavioural economics is still in its infancy, but we
are now beginning to understand just how much humans are driven by instincts
such as herding. And nowhere is this more apparent than in the finance
industry.

The financial crisis drew to our attention – once again – the
crucial role of the finance industry. No industry that can cause such havoc
when it goes wrong should ever be regarded as irrelevant or superficial. On the
contrary: financial institutions perform the functions of capital allocation
and money transmission which are so vital to our economy. Disruption or
interruption of these functions, even if only for a brief time, has terrible
consequences.

Yet macroeconomists regarded the behaviour of financial
institutions and the motivations of those who work in the finance industry as
so unimportant that they could safely be ignored. Representative agent models,
flawed though they are, at least attempt to explain the behaviour of households
and firms: but the behaviour of banks, and things that don’t call themselves
banks but do bank-like things, stayed under the radar until far too late. Macroeconomists
described the finance industry as a “veil”, rather than as the beating heart and
circulatory system of the modern monetary economy: linear models, if they
included banks at all, portrayed them as passive intermediaries, rather than
active agents whose rational expectations are not necessarily aligned with
those of their customers or, indeed, with the best interests of the economy as
a whole.

The failure of most macroeconomists to foresee the financial
crisis grew out of their incorrect understanding of how money is created, and
perhaps more importantly, how leverage builds up. “Loanable funds” models,
which portray the role of the financial sector as intermediating existing
funds, are not only wrong, they are dangerous. They do not show how exuberance in credit creation arising from the irrational belief that asset
values can keep rising forever carries the seeds of its own destruction. And
they encourage belief in exogenous factors as the cause of financial crises –
the “Asian savings glut” springs to mind. The huge increase in broad money
prior to the financial crisis did not come from Asia, or from Mars. It was
created by American and European banks.

Leaving banks out of economic models, or – worse –
modelling their money-creating function incorrectly, made it impossible for mainstream economists to understand the significance of the build-up of credit that
led to the financial crisis. The warnings came principally from people outside
mainstream economics, particularly the followers of Hyman Minsky. After the
crisis, Minsky’s “financial instability hypothesis”, long consigned to a dusty
shelf in a dark cupboard, suddenly became hot news. Unsurprisingly, since we had just lived through something that looked very like a "Minsky moment".

Clearly, the exclusion of the financial industry from models
of the macroeconomy was a major omission. Equally clearly, the fact that
most macroeconomists did not, and to a large extent still do not,
understand the mechanisms by which money is created and circulated in the modern monetary economy,
is a big, big problem. Central banks are now “adding” the financial sector to
existing DSGE models: but this does not begin to address the essential
non-linearity of a monetary economy whose heart is a financial system that is
not occasionally but NORMALLY far from equilibrium. Until macroeconomists
understand this, their models will remain inadequate.

But macroeconomists are not oracles. It is their job to
identify trends, not to predict specific events; it is both unreasonable and dangerous of the public to
expect them to play the prophet. Macroeconomists have been cast in the role formerly held
by priests and shamans, a role they appear to have welcomed though they are
ill-equipped to perform it. They have garbed themselves with the cloak of
infallibility and the breastplate of omnipotence. The financial crisis stripped
them of these trappings, revealing them to be, underneath, somewhat skimpily
clad.

It is fair to say that the academic macroeconomists have done a lot of
soul-searching since the financial crisis, and there are important signs that
things are beginning to change. But some of the most influential people in
macroeconomics have spent their lives developing theories and models that have
been shown to be at best inadequate and at worst dangerously wrong. Olivier
Blanchard’s call for policymakers to set policy in such a way that linear
models will still work should be seen for what it is – the desperate cry of an
aging economist who discovers that the foundations upon which he has built his
career are made of sand. He is far from alone.

At the Bank of England's One Bank Research Agenda seminar yesterday, Deputy Governor Ben Broadbent commented:

Economists cling to old ideas in the face of overwhelming
evidence that they are wrong, or they choose the evidence that suits their
particular framing.

Macroeconomics has indeed failed: not because of an intrinsic inadequacy in the discipline itself, but because of confirmation bias and selection bias among macroeconomists. Who would have thought it?

Saturday, 21 February 2015

I have been mulling over the terms of the agreement between Greece and the Eurogoup. Initially, I thought that Greece had ended up with an appalling deal, getting almost none of its aims and losing control of EFSF funding for its banks. The retention of future primary surplus targets under the November 2012 agreement - only the target for this year is under review - seemed particularly harsh.

But then I listened to Pierre Moscovici explaining the thinking behind the deal, and suddenly the penny dropped. We've all been missing the point. Holger Schmieding of Berenberg Bank was on the right lines - he commented recently that the real problem in the Greek negotiations was that trust had broken down. Indeed it has. But not recently. Trust in Greece broke down a long time ago.

The most obvious breakdown in trust happened in 2010 when the extent of Greece's indebtedness was revealed - and the lengths to which it had gone to conceal its true position. With the help of Goldman Sachs, it had lied about its finances to gain admission to the Euro in 2001, and had been living a lie ever since.

Since then, successive Greek governments have failed to deliver agreed reforms or have chosen to implement so-called "reforms" that wrecked small businesses and bankrupted households without addressing the deep structural problems in the Greek economy. Greece has made an immense reform effort, but all it has to show for it is a tiny primary surplus, some illusory exports and a growth mirage. It remains deeply depressed: the Economist observes that its depression is now nearly as deep as that of the US in the 1930s and more prolonged. And its debt/gdp is now a shocking 181% of GDP. However well-intentioned these reforms are, they are not working.

But in fact Greece has a long history of fiscal mismanagement. It has had recurrent defaults: some estimate that it has spent half of the last 200 years in default. It has also had episodes of high inflation and even hyperinflation, which is one reason why restoring the drachma is unpopular.

The long history of mismanagement, coupled with Greece's underhand behaviour when joining the Euro, are the reason for the breakdown in trust. Other countries simply do not trust Greece to do what is necessary to restore its economy and repay its debts.

Syriza appears to have assumed that it would automatically be trusted by other governments. After all, it is a new government with no connection to the previous ones. It doesn't have a record of financial and economic mismanagement. It does have some lefty ideas, such as raising pensions and minimum wages and restoring collective bargaining, but these could be accommodated within a fiscally austere budget. And that is exactly what it has proposed. Its rock-star economist finance minister Yanis Varoufakis planned to run fiscal surpluses of 1.5% indefinitely, which is hardly profligate, and make structural reforms to encourage business, remove distortions and improve tax revenues. He complained that the reforms imposed by previous governments under the aegis of the IMF, ECB and European Commission were not good enough and he wanted to see far more extensive and radical reforms. And he wanted to "bail in" creditors by replacing existing debt with nominal GDP linked bonds, which would not pay out until growth improved and would therefore give creditors a direct interest in ensuring Greece recovered. To those of us watching on the sidelines, this did not appear unreasonable.

But it did to EU member state governments, particularly in creditor countries and - perhaps surprisingly - in some other periphery countries. They rejected his ideas out of hand and insisted that he had to stick to the terms of the existing agreement. This seemed harsh, and I - like many others - thought that these governments should give his ideas consideration. But the governments were not objecting to the economics. No, their real problem was that this government is Greek, and they don't trust the Greeks.

In effect, Syriza said to the other EU governments, "We aren't like the others: just let us do what we want and we will deliver growth and debt reduction". To which the others responded, "We've heard it all before. Why should we believe you are any more capable of doing this than your predecessors?"

This, in a nutshell, was the obstacle. Syriza wanted a new arrangement in which the rest of the EU would trust it to deliver on its promises. The rest of the EU wanted Syriza to prove its trustworthiness by completing the current programme. Deadlock.

It is to the considerable credit of the three institutions involved in the negotiation that this deadlock was eventually broken and an agreement established that gave Syriza some freedom of action while reassuring governments that existing commitments would be met. Indeed it appears to me that the IMF, EC and ECB have been broadly supportive of the Greek argument that the present programme is not deliverable in its entirety and needs to be renegotiated, and because of this more has been conceded than might have been expected. In short, the eventual agreement gives Syriza as much as it could realistically hope for and more than it had any right to expect.

The agreement essentially wipes out the current reform programme for the next four months, replacing it with a programme of reforms that the Greek government will specify and the EC, ECB and IMF will collectively approve. In parallel with this, and subject to institutional approval of the Greek government's proposed reforms, the national governments will extend Greece's bailout program until June 2015 to enable it to meet essential commitments. Funding to Greek banks will continue to be provided by the Hellenic Central Bank under the ELA facility, and there will be no imposition of capital controls. The initial list of reforms has to be submitted for institutional approval on Monday 23rd February. It will probably go through several iterations before being approved, and there will be a lot of chewed fingernails, but once it is approved national parliaments will be asked to approve the bailout extension.

There will then be further work to specify the agreed reforms in detail. The details, including implementation plans, must be agreed by the end of April. This will then give time for further negotiation of what could be a completely new programme. And then we will play the cliff edge game all over again in June when the bailout extension runs out and the new programme must be approved in time for Greece to meet its debt obligations in July and August.

So although the Greek government didn't get debt relief, and it didn't get a commitment to reducing primary surpluses from 2016 onwards (this will have to be negotiated on the basis of revised forecasts taking into account the effect of the new reforms), it got something much more important - the opportunity to prove that it can be trusted.

I can't emphasise too strongly how important this is. I've observed before that the value of currencies depends on the credibility of their sovereigns. But Greece is a Euro member. It is essential that ALL Euro member states are credible. If one is not, then the rest are also undermined because of the risk to the currency that they all use, and indeed to the institutions, the banks, the trade links and the information channels that they all share. No wonder the other states needed reassurance that Greece would meet its commitments. It is not just a moral argument about obligations. Their own economic stability is on the line.

This chimes very well with a key demand of the Syriza government - the call for Greece's "dignity" to be restored. People who aren't trusted have no dignity. They cannot be left to do things for themselves, unsupervised, or to make decisions for themselves if those decisions will affect the welfare of others. So it is with countries, too. Syriza cannot have the trust of other EU members just because it says it should have it. It must earn it. This agreement, rather than treating it as a basket case that must be told what to do and supervised closely, offers it the opportunity to earn that trust by doing the following:

creating a programme of credible and achievable reforms that will deliver the growth that Greece desperately needs

delivering the reforms agreed with the supervising institutions

meeting all of its existing commitments

If it can do this, then it will be trusted by others to deliver more - possibly including a complete programme of its own design. And in this way it will restore the dignity of Greece.

That's the challenge to Syriza. I hope it is big enough to accept it. But there is also a challenge to the rest of the EU.

The approval and supervision of Greece's programme has been given to the three institutions involved, the European Commission, the ECB and the IMF. It is fair to say that none of these has handled Greece's difficult situation well in the last few years. The IMF was the first to recognise its failings, producing several pieces of research that identified deficiencies in its handling of the Eurozone crisis in general and Greece in particular. As time has gone on, it has looked increasingly uncomfortable with the harsh austerity imposed on Greece. The ECB, too, worried about the severe demand squeeze in much of the periphery, has been trying to find ways of reflating the Eurozone economy without breaking fiscal rules. And the latest to the party is the European Commission, which under the leadership of Jean-Claude Juncker appears to wish to soften the fiscal stance and increase investment. All three institutions are quietly supportive of Greece's argument that austerity is too severe and needs to be relaxed.

But some key member states are not so supportive. For them, austerity is something to be endured in the expectation that reforms will pay off and growth resume. Germany's Wolfgang Schaueble was criticised by many people, including me, for his uncompromising attitude. And there are features of the agreement that do seem to be particularly aimed at soothing frayed German nerves: at the press conference, Jeroen Dijsselbloem said the reason for transferring HFSF funds back to the EFSF was to ensure that they could only be used for recapitalising banks and not to shore up the sovereign finances, which was a key worry of the German delegation. The insistence that the November 2012 agreement must remain in place for the four months is also a concession to member states worried that removing the existing framework completely would give Greece carte blanche to reverse all the reforms it has made. Evidently the supervising institutions still have some work to do to win the trust of member states, too.

It is therefore a considerable concession for member states to relinquish their
power of veto over Greece's reforms to three institutions that have a
chequered history and now appear to have a somewhat softer approach than some member states would really like. And it subtly shifts the power balance within the EU, away from
Germany-hegemon and towards institutions. Taken in conjunction with
President Juncker's ideas about creating a Eurozone-level elected body,
this seems to move the Eurozone further down the road towards fiscal and
political union.

Both Greece and the EU institutions should therefore appreciate the sacrifice of sovereignty made by Germany and others in this agreement. And both Greece and the EU institutions bear responsibility for making sure that it works. The IMF does, too, but its involvement will be short-term: Christine Lagarde explicitly stated in the press conference that the IMF programme ends in March 2016, which is long before any new EU programme for Greece would complete. As the IMF steps back, the maturing EU institutions must pick up the reins.

As Schaueble put it in his post-agreement press conference, "in the end this is not about a particular country, it is about the EU". And it is the whole EU which will gain if this all turns out well.

Wednesday, 18 February 2015

Greece's battle with the Eurogroup over its debt and bailout terms is heating up. And both sides have deployed a new and powerful weapon. The draft communique.

It all started with the draft communique presented to the Eurogroup finance ministers meeting by Jeroen Dijsselbloem. This was leaked to the press by the Greek delegation, complete with angry annotations, before the meeting even started. When the Greeks rejected it, therefore, the press already knew both the contents of the communique and the reasons for its rejection. Round 1 to the Greeks.

And Round 2, as well. After the meeting, Yanis Varoufakis held a press conference in which he complained that the draft presented to the meeting was not the draft he had discussed with the European Commission's Pierre Moscovici, which he said he had been "happy to sign". A draft purporting to be the "Moscovici draft" was duly leaked to Channel 4's Paul Mason. Unsurprisingly, it contains none of the commitments to the "current programme" of the earlier leaked draft, except in the context of transition to a "new arrangement".

But the Eurogroup was not going to let the Greek delegation win this battle. Later that night, the "right" version of the "Moscovici draft" was also leaked to the press. This was welcomed by various commentators as being "pro-Greek", because it acknowledged Greece's concerns about social cohesion and the humanitarian crisis. But as I pointed out here, it also locked Greece into the current programme without relief: all it offered was a possible softening of imminent targets, which would have to be made up by harsher austerity later. It was, in reality, a combination of the "Moscovici draft" and the "Dijsselbloem draft".

The release of this third draft was accompanied by lots of complaints about the Greeks' failure to produce a draft of their own. If the measure of success was the number of drafts produced, the Eurogroup was winning three-nil. "Over to you, Greece", ran the headlines. Round 3 to the Eurogroup.

This didn't go unnoticed in the Greek camp. Drafts, pah. They came up with an offer. The trouble was, the press didn't understand the offer. It was in Greek. The FT reported that Greece would seek "an extension of its international bailout". This would be a major climb-down by the Greek government, which has insisted that the bailout program will not be extended (and was elected on this basis). Once again, people were left scratching their heads. Why would they give in now?

The ever-helpful Yannis Koutsomitis contributed the following Google translation of the Greek offer:

It seems the FT was completely wrong. The Greeks have actually refused to request an extension of the bailout programme. They are intending to request an extension of the loan agreement WITHOUT the bailout programme.

The rejected items are from the "Dijsselbloem draft". Greece has refused to agree to complete the current programme, refrain from unilateral action or cooperate with "European and international partners" (which is code for the Troika, of course) on fiscal policy and structural reforms. That was always its stance: there has been no "climb-down".

The "points for discussion" are derived from the second "Moscovici draft". But there is a subtle change. This is a very rough translation, of course, but differences in wording are important. The second "Moscovici draft", released in English by the Eurogroup, says this:

Measures for reducing the debt burden and achieving a further credible and sustainable reduction of the Greek debt-to-GDP ratio should be considered in line with the commitment of the Eurogroup in November 2014.

But the Greek delegation appears to have taken advantage of the language difference to make a subtle alteration:

Measures to reduce the debt burden and achieve a further sustainable reduction of the Greek debt to GDP ratio should be calculated along with the commitments of the Eurogroup of November 2012.

This does rather change the meaning, doesn't it?

And the paper battle continues. The Greek government has now released to the press the presentations and associated "technical documentation" provided to the Eurogroup. Reports from Eurogroup sources that the Greek delegation made no credible offer seem to have been "economical with the truth", to put it mildly. According to Kathimerini (Google translation, original Greek here):

It shows that Mr. Varoufakis accepted the extension of the loan agreement, but not the program, while reference was made and the commitments it undertook to bring out the government during the "bridge program" proposed for the next 3-6 months.These are:

- Reduction of bureaucracy.Documents produced by the public administration should be presented to citizens.

- Strengthen the independence of tax administration.

- Creating an efficient and fair system of tax litigation matters.

- Modernization of bankruptcy law.

- Reform of the judicial system.

- Developing a competitive and healthy environment in broadcasting that enhances the transparency and tax revenue.

- Dissolution of various cartels.

And from Mr. Varoufakis's presentation to the Eurogroup on Monday:

"To sum up, our government is ready and willing to apply for an extension of the loan agreement by the end of August (or until whenever the Eurogroup judge), to agree on a set of reasonable conditions to be fulfilled in this period and commit in making a complete evaluation by the European Commission at the end of the interim period.A period which will allow Greece and its partners to create a new contract for the development of Greece".

So, to sum up, Athens' offer contains no commitment to completing the current programme, but does include commitments to complete certain structural reforms that form part of the current programme. Subtle, much?

And it is also now clear where the battleground is. Both sides seem to have taken to heart Bulwer-Lytton's famous adage, "Beneath the rule of men entirely great, the pen is mightier than the sword". No longer simply spectators, journalists have become part of the game. I wonder how the world's press will react to being used as a weapon?

UPDATE. Via @WEAYL on twitter, the full set of Eurogroup documentation released to Kathimerini is here. It includes Yanis Varoufakis's presentations to the Eurogroup meetings on 11th and 16th February, with associated technical documentation, plus the Dijsselbloem and second Moscovici draft communiques. Looking at this, it is very hard to argue that the Athens government has not been specific about its plans, or that its plans are unreasonable. Round 4 to Syriza, I think.

Saturday, 14 February 2015

From the OECD comes this chart showing which countries have done the most since 2007 to reform their economies: (h/t London Analyst):

Isn't this marvellous? All those who say Greece hasn't done any reforms now have egg on their faces. Greece deserves hearty congratulations for its reform effort.

And as the headline says, all those reforms are paying off, aren't they?

From the OECD's Economic Outlook dataset for November 2014, here is the GDP growth of the five best reformers since 2007:

And here's the GDP growth of the five countries that have done the least reform since 2007:

Since the GDP growth in 9 of the 10 countries is actually lower in 2014 than it was in 2007, and the tenth country (the USA) has made no significant reforms, it is not evident from these charts that "reform" makes any difference at all.

Ah, you say, but that is because we have not allowed reforms long enough to work.....

But Germany made painful reforms in the early 2000s. Surely a decade is long enough for reforms to be bearing fruit? Yet its GDP growth is worse than the USA.

And if you happen to live in Slovakia, you could be forgiven for believing that "reform" makes you substantially poorer.

But actually this set of results has something much more interesting to tell us. I've removed the USA and Sweden from the following chart, and added Finland, so it shows only the best and worst Eurozone reformers. (I've also removed Slovakia from this chart because it is an outlier in this dataset due to the omission of other East European countries.)

Notice anything?

The bounce back of non-reforming countries from the 2008-9 crisis was short-lived. Finland, Germany, Belgium and the Netherlands all suffered a sharp drop in GDP growth in the Eurozone crisis. In short, their GDP growth both before and after the crisis was unsustainable.

It is hard not to conclude that the bounce back of non-reforming countries after the 2008 crisis was achieved at the expense of their weaker Eurozone partners, who were unable to bear the burden. When they collapsed, what was in effect an aftershock from the 2008 crisis transmitted itself back to the non-reforming countries, who were then forced to absorb what they had tried to avoid. Understandably, they were angry. And still are. Hence the stony refusal by these countries to consider proposals for a gentler approach to reform.

It is not clear to me why countries whose GDP growth is on an
unsustainable path and vulnerable to external shocks should be
excused reform. Though GDP growth for these countries appears to be converging on to a lower path: it seems the "reforms" of weaker countries are forcing stronger ones to temper their expectations.

However, this is not as good as it appears. Because stronger countries have learned no lessons, they seem intent on continuing their beggar-my-neighbour policies outside the Eurozone. And their lower GDP growth expectations don't encourage intra-Eurozone trade to develop. This is not viable. The future of the Eurozone depends on stronger intra-Eurozone trade and a more cooperative approach.

The non-reforming countries need to reconsider their position. The enormous trade surpluses of Germany and the Netherlands are nothing to be proud of: the corollary to them is poor domestic investment, as this chart for Germany shows (h/t Schuldensuehner):

The reforming countries have made deep and painful cuts to domestic consumption - hence their recessionary economies - and rebalanced towards exports. Now it is time for the non-reformers to reform. They must increase domestic investment and raise consumption. Without that, the weaker countries cannot recover. And without recovery for the weaker countries, the Eurozone is doomed.

Thursday, 5 February 2015

The ECB has abruptly announced withdrawal of the "waiver" under which it was prepared to accept Greek sovereign bonds as collateral for liquidity. This created a considerable Twitter storm, with lots of angry people saying the ECB's action was beyond its mandate and far too precipitate: it should at least have waited for the Greek Finance Minister, Yanis Varoufakis, to meet his German counterpart, and it should not be acting as if the bailout programme was ended when negotiations were still proceeding. I admit, I was one of those people.

And I stand by my views. The ECB is acting far beyond its mandate in seeking to influence negotiations between Eurozone member states regarding the terms and conditions under which member states lend to their distressed partners. It has no business interfering in fiscal policy: if the Greek government decides to run 1.5% fiscal surpluses instead of 4.5%, hike minimum wages and create lots of government jobs, it is none of the ECB's business. The ECB's monetary policy failures are legion: it should put its own house in order, rather than interfering with the conduct of fiscal policy. And worse, its persistent interference in fiscal policy is a clear conflict of interest, as the Advocate General of the European Court of Justice noted in relation to the OMT programme. It should not be a member of the Troika at all, and certainly should not use changes in fiscal policy by a democratically-elected sovereign government - even one that has inherited an economy in tatters with a massive debt burden - as justification for limiting liquidity to that country's banking system. Monetary policy should never be used to serve fiscal or political ends. Not ever.

Firstly, there is the timing. The Syriza government has now been in power for ten days. Why did the ECB wait until now to pull the plug on the waiver? It might simply be that today was the first planned meeting of the Governing Council. But that doesn't exactly suggest that this is an urgent problem - so why is the ECB doing this now, given that the bailout extension is not until 28th February and Greece has already asked for time to come up with an alternative plan?

Secondly, there is the timing. (Yes, I mean that). Varoufakis met ECB chief Mario Draghi yesterday and he meets German Finance Minister Wolfgang Schäuble today. In between those two meetings the ECB pulled the waiver. Why? Well, Schäuble is openly hostile to Varoufakis's ideas of debt relief and an end to austerity, while Draghi has so far kept very quiet (though his deputy Vitor Constancio has been more forthright). Schäuble will no doubt be looking for explicit backing from the ECB. Should this action be taken as the ECB's governing council signalling whose side it is on?

Note the date. Yes, you read right. Over 6 months ago, Varoufakis predicted that the ECB would attempt to pull funding from the Greek banks.

Of course, today's action is not pulling funding from Greek banks, since they can still pledge other assets at the ECB. But all funding using any form of Greek sovereign debt must, from 11 February, be obtained from the Hellenic Central Bank under the Emergency Liquidity Assistance (ELA) scheme. And the ELA scheme itself is under the control of the ECB and reviewed bi-weekly. The ECB could pull it at any moment.

Varoufakis's comment is undoubtedly a reference to the fact that pulling ELA from Greek banks would cause their sudden disorderly collapse. The ECB has used this trick before: it threatened to pull ELA from Irish banks in 2010, and it actually pulled ELA from Cyprus's Laiki Bank and the Bank of Cyprus, forcing immediate closure and restructuring. This second piece of brinkmanship resulted in the worst bank bailout decision in the history of the planet, which was (fortunately) subsequently overturned by the Cypriot legislature. Undermining deposit insurance is almost criminally insane.

But pulling ELA from Greek banks would have a much larger impact. Germans fantasise that ELA can be pulled without systemic impact, but this is not remotely credible. The impact would be smaller than it would have been in 2010, but it would still be highly destabilising to the global financial system. Such an action would greatly enhance the ECB's reputation for incompetence and probably end the careers of its senior officials.

If the collapse of the Greek banks precipitated the disorderly exit of Greece from the Euro, there would be significant losses for the ECB itself, the other Eurozone governments and probably the IMF. The impact on the European economy would be devastating and it would send shock waves around the world. And it would set an important precedent. If one member state can leave, so can others. How can the ECB have any credibility as guardian of the Euro if it is seen to be actively forcing out member states?

If the ECB forced a banking collapse by pulling ELA, Greece might try to limp on within the Eurozone as Cyprus did, using capital controls to prevent capital flight. But this would be the worst possible situation for Greece and it seems highly unlikely that the Greek government would even consider it. Greece's economy is already in worse shape than Cyprus's was at the time of its banking collapse, and Cyprus's banking system was crippled but not destroyed by the restructuring. Greece's banking system would be wrecked beyond repair. Greece would have no choice but to create a completely new currency and reflate its economy directly via the central bank. That means leaving the Euro, at least temporarily.

So as Varoufakis said, the ECB's threat to pull ELA appears to be empty. I said on Twitter that I thought the ECB's action was sabre-rattling. Karl Whelan, it seems, thinks so too. "Relax, it’s no big deal. Just some muscles being flexed." he says at the start of this blogpost. But whose feathers is the ECB trying to ruffle? Lorcan thinks the target is Greece:

So, all together, the move from the ECB should have very little
immediate effect on the Greek banks, provided there is not a
complete loss of confidence in the Greek banking system in the coming
days, and should be viewed as what it is: The ECB is pressuring
the Greek government.

Greece's finance minister, Yanis Varoufakis, has been agitating for
Greek debt relief since his appointment after January's election. Today
the ECB gave its answer to his moves. If the Greek government does not
agree to reenter a program, the ECB will not allow its debt to be used
as collateral.

I don't believe it. If this is the ECB's intention, it is playing right into Varoufakis's hands. It's as if a chess player
deliberately chose to adopt the exact game strategy that his opponent,
six months before, had published in a chess magazine. Draghi is
every bit as good a game theorist as Varoufakis, and the two men met
before the ECB's decision. It's just not credible that Draghi would unintentionally adopt Varoufakis's game strategy.

Is it possible that this is not an antagonistic move at all, from Greece's point of view? Could it be that far from kicking Greece, the ECB's real target is Germany? For some time now, it has been evident that
Draghi is no fan of Germany's "Austerity Forever" stance. Pressuring Germany into
negotiating might be his intention. But if so, it is a highly risky
strategy. Pulling the waiver is likely to increase capital flight from
Greece and raise Greek bond yields still further, putting further
pressure on Greece's fragile finances. How exactly would this help Greece?

Alessandro Del Prete helpfully sent me this piece by Jacques Sapir which explains how weakening Greece's position could actually strengthen its hand (my emphasis):

In this strategic game, it is clear that Greece has deliberately chosen
the strategy qualified by Thomas Schelling, one of the founders of game
theory, but also of nuclear dissuasion, as « coercive deficiency »[5].
In fact, this term of « coercive deficiency » was imagined by L.
Wilmerding in 1943 in order to describe a situation where agencies enter
into expenses without prior financing, knowing that morally the government will not be able to refuse funding them [6].
Schelling’s contribution consists in showing that this situation can be
generalized and that a situation of weakness can reveal itself to be an
instrument of coercion upon others. He also showed how it can be
rational for an actor knowing himself to be in a position of weakness
from the start, to increase his weakness in order to use it in
negotiation. Reversing Jack London, one can speak in this instance of a
“strength of the weak.” [7].
It is in this context that we must understand the renunciation by the
Greek government of the last slice of aid promised by the so-called
« Troïka, » amounting to 7 billion euros. Of course, having rejected the
legitimacy of said “Troïka, » it could not logically accept to take
advantage of it. But, in a more subtle way, this gesture is putting
Greece voluntarily at the edge of the abyss and demonstrates all
at once its resolve to go the bitter end (like Cortez burning his ships
before moving up to Mexico) and to increase the pressure on Germany. We
are here in a full blown exercise of « coercive deficiency ».

This explains Varoufakis's "Do ahead" (he probably meant "Go ahead"). He stands at the edge of the cliff, and the ECB says "Do what we want or we will push you over". His response: "Go on then, push".

It must be remembered that this game is being played on a global stage. The US President, Barack Obama, has openly sided with the Greeks, warning that "You cannot keep on squeezing countries that are in the midst of a depression. At some point there has to be a growth strategy in order for them to pay off their debts and eliminate some of their deficits". And the UK's George Osborne, while calling for the Greek finance minister to "act responsibly", also criticised the Eurozone for its lack of a coherent plan for jobs and growth. Calling for the two sides to strike a deal, he warned that the standoff between Greece and the Eurozone is the "greatest risk facing the global economy". This seems like hyperbole to me, given the continuing crisis in Ukraine and military game-playing in the South China Sea, not to mention the Islamic insanity in the Middle East. But it all helps the Greek cause.

Varoufakis is gambling that the Eurozone, and more particularly Germany, will not dare to push him off the cliff because of the consequences for international political relations. If Germany was seen to force Greece out of the Euro by refusing to negotiate, it would become an international pariah. There are already voices reminding Germany of its own debt forgiveness in 1953, and anti-austerity movements in many other Eurozone countries would only be encouraged by Germany and/or the ECB looking like bullies. Forcing Greece out of the Euro could result in the disorderly unravelling of the whole thing.

I may be completely wrong, but this looks far more plausible to me than a simple explanation that fails to take account of the signals given by both Varoufakis and Draghi. In which case, Schäuble should beware. His position is nowhere near as strong as he thinks. He is dangerously close to the cliff edge himself. If Germany pushes Greece over the edge, Greece may well take Germany down with it.

About Me

In a past life I worked for banks...now I write about them. Actually I write about finance and economics generally. And about anything else that interests me - so you may occasionally find posts on this site that have nothing to do with banking, economics or finance. In fact they might have something to do with music, since I'm a Associate of the Royal College of Music and a professional singer and teacher. I'm also an alumnus of Cass Business School, where I did an MBA with a specialism in finance and risk management.
I'm very happy to accept comments on my posts, but if you have questions about something I've written that you don't want to discuss in the comments, do please email me at francesmcoppola@gmail.com.
My professional blog as singer and teacher can be found at singingiseasy.blogspot.com.